How to Read a Company's Financial Statements: A Complete Guide

To read a company’s financial statement is like standing under the hood of a car to see how the car works; it is a must to understand to any investor, analyst and business leader the financial reality of an organization. Financial statements are not dry, uninspired spreadsheets for accountants to look at, but are eye candy which tells you a lot about a company’s performance, profit and the way it’s working. A financial analyst needs to know that the three main pillars of financial reporting are the balance sheet, the income statement and the cash flow statement and each of them provides an eye to the picture.

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The journey starts with the income statement (often referred to as the profit and loss statement) which summarizes a company's revenues and expenses for a period of time (say 1/3 or 1/4 of a year) and describes how much money the company earned selling its product or service. As you go down the statement, different expenses are subtracted, starting with the cost of goods sold to show gross profit. Operating expenses include marketing, research, administrative costs and depreciation. The bottom line of the income statement is net income or profit, and that is where the company actually makes money after all its operational costs, interest obligations and taxes are paid.

Next is the balance sheet, which represents the financial snapshot of a company at one point in time and is based on the accounting equation that assets must equal liabilities plus shareholders' equity. Assets are all the value the company has, divided into current assets (cash, accounts receivable, inventory that can be turned into cash in a year) and non-current assets (property, plant, equipment or long-term investments). Liabilities are everything the company owes to external parties, divided into short-term liabilities (supplier bills) and long-term debts (corporate bonds or bank loans). The shareholders' equity is the remainder of the business's net worth (the money left over to the actual owners after all the debts have been subtracted from the assets) that is retained earnings and capital injected by investors.

A profitable income statement does not necessarily mean a company is swimming in cash, so the cash flow statement is a reality check for any financial sleuth. This statement tracks the actual flow of cash in and out of the business and it breaks it down into three parts: operating activities, investing activities and financing activities. Operating cash flow tells you if the business is really generating cash or not, filtering out the non-cash accounting items like depreciation. Investing cash flow is capital expenditure in the form of new equipment or acquisitions of other companies. Financing cash flow is a way to track debt and equity issuance and dividends paid to shareholders. When you combine all of that information from the income statement, balance sheet and cash flow statement with one another, you really get a good idea of what the company is in and how it is going to be able to survive and develop and become wealthy in the long term.